Summary

Digital connectivity is vital to our lives. It now underpins nearly all areas of the economy, it plays a crucial role in our culture and society, and it is increasingly central to our health and wellbeing. The purpose of this inquiry has been to explore how the full benefits of digital connectivity can be extended to all, regardless of location, across the UK.

The goal of providing better, wider access to fast broadband and mobile services has been a Government priority since 2010. So far the UK has done well compared to other EU countries on the provision of superfast broadband services in terms of geographic coverage, take up and lower prices, all achieved through a competitive market. Over £1.7 billion of public money is expected to be invested in closing the digital divide that has emerged between those who do and do not have access to faster services, mainly but by no means entirely in rural areas.

However, while the Government’s broadband programme, BDUK, is on track to deliver access to 95% of premises with superfast services by the end of 2017, there is a serious public concern that the UK is not adequately investing in critical telecoms infrastructure. The UK is a laggard by international standards in providing fibre connectivity. This could result in a widening, not a narrowing, of the digital divide; especially as demand for faster services escalates after 2020.

UK broadband access infrastructure is dominated by BT’s local access network subsidiary, Openreach. Openreach, local bodies and BDUK are to be congratulated for hitting their 90% coverage target for superfast broadband. But one consequence of this rapid rollout has been that the programme appears to have tackled the easier-to-reach premises within the interventions areas first and has not delivered coverage to whole areas. Instead, it has left a patchwork of premises that have not been reached, and created much uncertainty among local residents as to whether or not they will be connected or receive improved speeds.

A further downside of the BDUK programme has been the lack of transparency in Openreach’s costs and deployment plans, the apparent effect of which has been to stifle local competition and thwart other network providers’ planning. At the same time, Openreach’s historically poor service record has failed to improve in the face of escalating demands on the network.

One difficulty in driving forward the BDUK programme is the need not to discourage private investment in infrastructure by preferring one technology over others, when that technology may not ultimately be the best for the future. Yet in reaching some of the harder-to-reach premises there will need to be judicious deployments of interim technology solutions to provide improved connectivity to those households and businesses which currently have little or no coverage.

The Government has determined that probably the most effective way of providing access to broadband for those in the “final five percent”, whether in rural, urban or suburban not-spots, is through the introduction of a Universal Service Obligation (USO) whereby a householder or a small business would have the legally enforceable right to an affordable and reliable internet connection. Ideally, a new broadband USO should be designed so as to encourage investment without overly burdening industry, creating consumer detriment or inhibiting take-up. The goal is to raise the minimum standard for all, not to privilege an already well-served minority. As such, there will be no advantage in setting the USO’s speed and other specifications too high, especially on introduction.

We believe that the Government is right to follow Ofcom’s advice to set the USO initially at a minimum of 10Mbps. However, the need for an increase in the USO minimum download speed to 30Mbps by 2022 is entirely foreseeable, and the Government will need to make active plans for this eventuality. Wherever it is realistic, the Government and Ofcom should ensure that the design of the broadband universal service should use and extend existing commercial and community networks, rather than displacing them.

On the mobile side, the Government and Ofcom have worked well together to secure investment from all four network operators to achieve 90% geographical coverage for voice and text by 2017. Ofcom has successfully designed spectrum auctions so that coverage obligations are a key part of these exercises. To facilitate investment by the operators, the Government may well need to place additional emphasis on achieving coverage, and on the role that mobile will play in meeting the universal service obligation for broadband, rather than primarily maximising revenue from auctions. Ofcom will also need to provide accurate information on mobile coverage so that the consumers can make informed decisions and also hold the mobile network operators to account on their investment and coverage commitments.

A central question throughout our inquiry has related to the nature of BT Group’s relationship with Openreach and, relatedly, Openreach’s performance in network development and the maintenance of telecoms infrastructure. Although functional separation was a key outcome of Ofcom’s 2005 telecommunications review, Ofcom’s Digital Communications Review (DCR) this year has made clear its concern at the continuing effects of the embedded conflict of interest between BT as service provider and Openreach as local access infrastructure subsidiary. It has concluded that further reform is required.

Openreach’s poor quality of service is one of the single biggest issues highlighted in the DCR. Although standards of service, specifically customer service, are also problematic in the wider industry, Ofcom has in particular identified the quality of Openreach’s wholesale service to communications providers, including to BT’s businesses, as being highly unsatisfactory.

Further concerns expressed about BT have been that Openreach has been “over-earning” substantially in relation to its cost of capital while Openreach’s investments, including in fibre, have until this year barely increased since 2009.

In our judgment, there appears to be compelling evidence that BT Group is exploiting the position of vertical integration to make strategic decisions that favour the Group’s priorities and interests, at the expense of its access infrastructure business. BT does not lack access to capital. Its current structure allows it to use Openreach’s utility-type assets to cross-subsidise riskier activities elsewhere in the Group, while significantly under-investing in the access infrastructure and services on which a large part of the public rely.

Ofcom regulates for competition, and its charge control regime has kept a downward pressure on prices, so that the UK’s communications prices are among the lowest compared with similar EU countries. But this mechanism has not been successful in holding Openreach to an adequate quality of service; and it is an open question how effective overall it has been in stimulating investment in Openreach’s infrastructure.

We now believe there is a pressing need to liberate more of BT’s financing for investment in broadband and the evolution of its telecoms infrastructure. As a result there is a need to consider closely BT’s governance and capital structures as well as the adequacy of its oversight and regulatory arrangements.

These questions raise a host of formidable technical and financial issues. To help address these, we retained a group of expert advisers including nationally recognised specialists in finance, regulation, communications and infrastructure provision. The expert panel compiled their analysis and conclusions in a separate report, which has been included as an Annex.

It came as a surprise to us that BT employs an investment hurdle rate significantly above Openreach’s actual cost of capital, as estimated and allowed for by Ofcom. This means that a potentially very significant amount of annual investment in broadband access and services, investment that would likely add to shareholder value, is not at present being made. While we understand the desire for BT and other providers to balance infrastructure investment with their own commercial interests, this forgone investment in maintaining, upgrading and supporting Openreach’s infrastructure is, according to our expert panel, damaging to public welfare, to shareholders and to consumers. BT should therefore take immediate steps to invest further in Openreach infrastructure and services, down to its cost of capital.

We have considered the case for establishing a standalone broadband utility provider using a regulatory asset base model. While the concept of having a single system operator could in theory be conducive to the management of a universal service obligation for broadband, we believe the differences between the communications market and other traditional utility markets make this approach unattractive. In particular, it is not clear how the presence of a utility-style operator would be compatible with promoting competition, or would work successfully alongside current market players such as Virgin Media, to say nothing of the many other smaller providers of broadband access infrastructure, without stifling competition and the growth of alternative networks.

In our judgment, Ofcom set out a very cogent case in its Digital Communications Review for the full separation of Openreach from BT Group. However, it stopped short of making an outright recommendation for such action at that stage given concerns over possible difficulties of implementation, disruption to investment, impact on the BT pension fund, as well as an apparent threat by BT of litigation. It is a very difficult judgment call as to whether the benefits of full structural separation would outweigh the likely significant disruption and fall-out to the wider industry and consumers. However, there is good reason to suggest that a more independent Openreach might increase infrastructure investment significantly.

We believe Ofcom has been right not to rule out full separation; that option should be kept firmly on the table. Ofcom has said that the proposals BT has offered to date on governance, performance, status and other arrangements of Openreach have not gone far enough. In our judgment Ofcom must remain resolute in its negotiations with BT, to ensure that the reform necessary to establish the quality and availability of communications services needed for UK consumers and businesses is delivered. If the regulator were to place more emphasis on Openreach’s quality of service, BT would voluntarily invest more in the infrastructure to avoid significant penalties. Should BT fail to offer the reforms and investment assurances necessary to satisfy Ofcom’s and our own concerns, then the regulator will need to set in train the steps to enforce full separation of the Openreach business.

In any event, in order to cement Openreach’s independence, we recommend that in future Openreach should be required to develop and publish a five-year strategic investment plan for comment and agreement with the BT Group Board. This would enable it to set out its financial needs, in a transparent and comprehensive manner. Should Openreach remain part of the BT Group under a strengthened model of functional separation, BT should be obliged to allow Openreach to raise finance independently in the capital markets in its own right, and to make investments that meet the business’s own cost of capital. We have every reason to believe that Openreach would be a very attractive investment vehicle to longer-term institutional investors, which could in turn facilitate increased investment in infrastructure.